Set out the ways agency costs can influence a firm's payout policy
The idea
Payout policy is partly a tool for managing conflicts of interest. Between shareholders and managers, surplus free cash flow tempts managers to build empires or pursue pet projects. Paying it out limits that waste and forces the company back to capital markets, where it is monitored, so shareholders of cash-rich firms with few good projects often favour higher payouts. Between shareholders and bondholders the conflict runs the other way: a large dividend, especially one funded by new borrowing, moves value from creditors to shareholders by raising default risk. Bond covenants that cap distributions are the usual defence. The trap is assuming a higher payout always reduces agency costs for every stakeholder.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Analysis of Dividends and Share Repurchases
- Explain the expected impact on shareholder wealth and on a company's financial ratios of cash dividends (regular, extra or liquidating), stock dividends, reverse stock splits and stock splits
- Contrast the main dividend policy theories and, for a described dividend decision by a company, explain what each theory implies for its share value
- Explain what signals a company may send by starting, raising, cutting or omitting its dividend
- Set out what shapes the dividend policies companies actually adopt
- Work out and explain the effective tax rate borne by each currency unit a company earns, under double-taxation, imputation and split-rate tax regimes
- Contrast a stable dividend policy with a constant payout ratio policy and work out the dividend each would produce
- Outline how corporate payout policies have broadly changed over time
- Contrast the ways a firm can buy back shares
- Work out and contrast how a share buyback affects EPS when it is funded 1) from surplus cash and 2) with borrowed money
- Work out how buying back shares changes book value per share
- Weigh up returning cash through dividends against buying back shares
- Work out and explain how well dividends are covered, measured against free cash flow and against net income
- Recognise the traits of firms whose cash dividend may prove unsustainable